Our last update on ADP was on November 14 (See Article), when we reaffirmed our Buy rating, raised EPS estimates and raised the target price. In this note, we are still reaffirming our Buy rating, but taking down our EPS and target price, fairly similarly to what we did with Paychex (PAYX) in our April 3 note (See Article). The two payroll processing companies have their company-specific differences, but the negative impact they are about to feel from coronavirus implications, and, more importantly, the offsetting positive effects have been fairly similar.
Founded in 1949, Automatic Data Processing (ADP) is a provider of cloud-based human capital management services to employers, serving more than 760,000 clients worldwide. The company focuses on growth of a complete suite of cloud-based HCM solutions and HR Outsourcing solutions; it also leverages global presence to offer clients HCM solutions wherever their employment needs exist. To date, ADP remains a go-to marketplace for companies large and small, as well as the source of employment-related data for the US government.
Valuation
Longer term, we continue to anticipate meaningful revenue growth and margin expansion from the ADP platform, as aggressive growth in new clients will remain at the very least flat in 2020, according to our estimates, but should make up for that flatness in 2021 and beyond. However, we need to recognize that for now our valuation should reflect the realities of 2020: therefore, we are reducing our EPS from $6.47 to $5.98, while taking down our multiple from ~32x to ~28x, in line with the market multiple reduction. When we apply the multiple of ~28x to the 2020 EPS estimate of $5.98, we get the new target price of $170 (down from $207). As soon as the coronavirus noise clears and we have evidence of improvement in the payroll processing space, and ADP in particular, we will be happy to revisit our target price.
Why ADP is Still a BUY!
Capital return story remains a success! In our view, capital return will remain an important light at the end of the tunnel not only for payroll processing names, but for the payments industry as a whole. First of all, we expect the $5 billion of share buyback authorization to remain in place, with the company potentially taking advantage of the recent fall of the stock price. Further, we do not see ADP accepting any bailout funds from the $2 trillion stimulus bill that was recently passed; hence, there should not be political pressures to suspend the buybacks. Furthermore, the dividend remains solid, with the yield around 2.7%. With such a solid dual capital return story support, we believe that demand among investors, particularly on the institutional side, shall remain strong.
Market share gains expected in 2021-22: While we have seen evidence of market share gains against Paychex (some investors see the two payroll processors as essentially a duopoly, though we do not subscribe to such assessment), we believe that the coming months of 2020 will be too chaotic to prognosticate any such gains. In our view, when the dust settles, we could see the old pattern reemerging and ADP potentially attracting mid-tier clients from its top competitor via lower pricing. This development, however, is not likely before 2021-22.
Expect growth in new clients at around 8%: We still expect growth in new clients around 8% in 2020, primarily because new accounts have a strong lagging effect and are not tied to any particular quarter. Most accounts that should come on the books trace their origin from the second or third quarter of 2019.
Technological and cybersecurity improvements likely: We increasingly believe that ADP will begin investing in long overdue tech improvements, which also protect the company against one of its key business risks (see below). In the past, we estimated that ADP needs to invest as much $70 MM annually into tech improvements and we believed that at least $50 MM of such spending shall commence in the new year, i.e. 2020. However, we now expect the company to postpone nonessential activities until the following year: therefore, we are now modeling only $10 MM of tech spend for the year (accomplished during the first quarter) and thus we are cushioning the EPS blow by saving as much 8 cents.
Expect Revenue Growth Acceleration in 2021: This bullet does not change much from our previous note: just like we modeled earlier 50 bps of revenue growth acceleration in 2021 (note: not in 2020!), driven by incremental clients, similarly we are leaving it intact today. Alas, we no longer expect any upside to this number in 2021, but potentially in 2022.
Business Risks
We see the following risks as potentially negatively impacting ADP’s bottom line:
- Data breaches represent the core of today’s technology problems, particularly since ADP is responsible not only for servicing private businesses, but also storing government-sensitive data. This also applies to disruptions of ADP’s data centers. We are now identifying this as the main business risk for Automatic Data Processing.
- Increase in license requirements, which is becoming more and more relevant for ADP, as it branches out across Europe and Latin America.
- Intellectual property infringement is another very important risk, since barriers to entry in ADP’s business are fairly low and any theft of copyrighted data could lead to problems on the competitive landscape.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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